Open interest is defined as the number of options or futures contracts that are held by market participants at the end of each trading day. As a general rule, the larger the open interest and larger the trading volume, the greater the liquidity of the contract.
Investors and traders prefer larger volume and larger open interest, as the contracts become less expensive to trade and larger positions can be entered or exited more quickly. Volume may not necessarily translate directly to a change in open interest.
In a market dominated by traders who hold positions for less than 1 day, there may be large trading volume without a significant increase in open interest. However, nearly all volume may lead to an increase in open interest in contracts where traders choose to hold open positions for a longer period of time.
All futures and options contracts start with zero open interest, that is, where no traders have any positions when the contracts are first listed. Assume a first trade where a buyer purchases 10 contracts and a seller sells 10 contracts. After that trade, there is a total open interest of 10 contracts.
This means that open interest measures the number of contracts held long, or the number of contracts held short, but not the sum of the number of long and short contracts. To combine the number of long and short contracts would overstate the open interest in the listed market.
In subsequent trades, open interest increases when new contracts are traded, but not when existing contracts are transferred from one investor to another. For example, assume that the buyer of the long position decides to sell her 10 contracts to a new investor. This transfer of existing contracts does not increase the open interest.
However, if she purchased those 10 contracts from a new seller in the market, the open interest in that contract would grow to 20 contracts. Open interest at the expiration of the options or futures contract is zero, as all contracts must be settled for cash or physical settlement at the termination of the life of the contract.